Thursday, September 20, 2012

James Hamilton and Stephen Williamson recently commented on the Republican Party platform (pdf) which calls for a commission to investigate possible ways to set a fixed value for the dollar. Here is a fragment from the platform:

Determined to crush the double-digit inflation that was part of the Carter Administration’s economic legacy, President Reagan, shortly after his inauguration, established a commission to consider the feasibility of a metallic basis for U.S. currency. The commission advised against such a move. Now, three decades later, as we face the task of cleaning up the wreckage of the current Administration’s policies, we propose a similar commission to investigate possible ways to set a fixed value for the dollar.

JDH was puzzled about the odd timing of an appeal to the gold standard, given a decade of low (sometimes negative) inflation. I left my thoughts on JDH's blog. Gold bugs tend to be conspiracy theorists... but here I think I've one-upped them by placing them within their own conspiracy theory box:

One theory here is that politics are driven by that class that has enjoyed the most recent financial success. Hard core gold bugs have surely enjoyed plenty of success over the last ten years, and are therefore capable of using their financial clout to get their favored policies onto the radar screen.

Note that the last Gold Commission was brought into law by Jessie Helms in October 1980. Gold had run up from $35 to $850. According to Anna Schwartz, that was the third bit of pro-gold legislation enacted by Helms:

"On his initiative, the right to include gold clauses in private contracts entered into on or after October 28, 1977, was enacted (P.L. 95-147). The program of Treasury medallion sales, in accordance with the American Arts Gold Medallion Act of November 10, 1978, was a second legislative initiative of the senator (P.L. 95-630). He was unsuccessful in subsequent efforts in 1980 to suspend Treasury gold sales and to provide for restitution of IMF gold."

Rumour has it that that Helms was friendly with the gold lobby.

So like the late 70s, the gold lobby's commodity of choice has risen in value, therefore their political agenda benefits from a large financial tailwind.

Just a theory, of course.

On a side note, Hamilton linked to an old paper he wrote called The Role of the International Gold Standard in Propagating the Great Depression (or here). The thrust of his paper is that in a gold standard, speculators are continuously evaluating the probability of changes in a currency's peg to gold. New conditions might cause a speculative run, with both that run and the government's response being potentially destabilizing. Hamilton points out that the run on the dollar in fall of 1931, and the Fed's response to this run - a dramatic increase in discount rates - helped propagate the Great Depression. Here is a paragraph, my emphasis in bold:

It sometimes is asserted that a gold standard introduces “discipline” into the conduct of monetary and fiscal policy where none existed before. Indeed, this was the primary reason that the world returned to an international gold standard during the 1920s. I cannot think of a more naive and more dangerous notion. A government lacking discipline in monetary and fiscal policy in the absence of a gold standard likely also lacks the discipline and credibility necessary for successfully adhering to a gold standard. Substantial uncertainty about the future inevitably will result as speculators anticipate changes in the terms of gold convertibility. This institutionalizes a system susceptible to large and sudden inflows or outflows of capital and to destabilizing monetary policy if authorities must resort to great extremes to reestablish credibility.

To bring Hamilton's point into its modern context, just substitute the word "gold" with the ECB's Target2 settlement system. If gold convertibility can be doubted, so can Greek Euro convertibility into German Euro and vice versa, the parities of which are enforced by Target2. The uncertainty about the alleged fixity of rates has spawned a 1931-type panic out of those euro-currencies most likely to suffer from an adjustment in their conversion ratio. That's why the huge Target2 imbalances are there... more or less for the same reasons the US experienced huge gold outflows in 1931.

Monday, September 17, 2012

William Stanley Jevons, who coined the term "double coincidence of wants"

A while back I had an interesting conversation with David Andolfatto on his post Evil is the Root of All Money. This is surely one of the more catchy phrases developed by monetary economists, who tend to the less-flowery end of the literary scale. David fleshes out a model that shows how untrustworthiness, or evil (what is called a lack of commitment in the NME literature), can lead to the emergence of money.

David finds this interesting because his model doesn't need the absence of a double-coincidence of wants to exist in order to motivate a demand for money. The double-coincidence problem - the unlikelihood that two producing individuals meeting at random would each have goods that the other wants - has historically been the explanation of choice for the emergence of monetary exchange. After all, if one person doesn't want another's goods, she can still transact by accepting some third commodity that is itself highly liquid and therefore likely to be easily passed on come the next transaction.

I think David is pushing a catchy phrase too far. While I agree that a lack of double coincidence of wants is not necessary to explain monetary exchange, neither is a lack of commitment necessary to explain monetary exchange.

Imagine a world with no evil, and no, this isn't a John Lennon song. Individuals in that economy are 100% trusted to pay their promises, i.e. full commitment exists. But people are widely dispersed and suffer from the double-coincidence of wants problem. It will make sense to trade amongst each other using transferable personal promises. Each promise guarantees to pay out some quantity of goods produced by that individual upon that promise being presented for redemption. Because promises are far cheaper to hold and transport than actual goods, these promises, and not goods, will circulate along long transactional chains. When a promise is accepted by someone who actually desires the given good, that promise will be "putted back" to the promisor, the good will be delivered, and the promise canceled. Thus you get monetary exchange... without the evil.

One real-life example of such as system would be the bills of exchange market that existed during the medieval ages up to the early 1900s. See this paper, for instance. Start on page 23 when the discussion on transferability, assignability, negotiability, and endorsement begins if you want a flavour for the bills of exchange system.

Gavyn points out that in explicitly drawing attention to its job of controlling convertibility risk - ie. ensuring that all euros are the same - the modern ECB is becoming more like the IMF. Specifically, during Bretton Woods the IMF sometimes financed the balance of payments deficits of member nations in order to ensure the system of fixed exchange rates stayed, well, fixed. When it did so, the IMF was engaging in a mind game of sorts with the market, for the market knew that the IMF knew that the market knew that rates could be modified if attacked with enough force. In admitting to the world the existence of convertibility risk, the ECB is now displaying an IMF-degree of hyper self-awareness... for the first time.

In order to ensure that this financing was not permanent, the IMF would impose limits on the borrowing nation's finances. This is what the ECB is now doing, too, as Gavyn points out. For instance, in order to be able to participate in the ECB's new outright monetary transactions (OMT) program, nations will be expected to conform to basic ECB requirements or risk being dropped. This is the idea of "conditionality".

In the comments I brought up a comparison to the institution that the IMF could have been if Keynes had won his debate against Harry Dexter White: the International Clearing Union (ICU). I only point this out because having as many comparisons as possible might help shed clarity on the Target2 imbalance problem. It also just so happens that I am reading Barry Eichengreen's book Exorbitant Privilege which touches on this bit of monetary history.

The ICU was first put forward by Keynes in 1941. Much like the ECB clears all intra-European payments on its own books via Target2, the ICU was to have cleared all international payments on its own books. Where the ECB uses the euro, the ICU would have used the bancor. Keynes's purpose for establishing the clearing union was to ensure that each country would be "allowed a certain margin of resources and a certain interval of time within which to effect a balance in its economic relations with the rest of the world" (Proposals for an International Currency (or clearing) Union, February 11, 1942). This would allow the war-ravaged world to return to an era of unfettered free trade rather than isolationism, especially the sort that prevailed in the inter-war years in which narrow bilateral clearing agreements were the norm.

What is interesting is that unlike Target2's open ended granting of credit, Keynes envisioned that the ICU would set explicit limits on any country's deficits. Here is (presumably) Keynes:

Measures would be necessary to prevent the piling up of credit and debit balances without limit, and the system would have failed in the long run if it did not possess sufficient capacity for self-equilibrium to prevent this. (Proposals
for an International Currency (or clearing) Union, February 11, 1942)

It really is too bad that the architects of the Euro never bothered to read that gem. Here, for instance, are the specific fine-print defining the maximum ICU debit:

The amount of the maximum debit balance allowed to any member-State shall be determined by reference to the amount of its foreign trade, and shall be designated its quota... The initial quotas might be fixed by reference to the sum of each country's exports and imports on the average of (say) the three pre-war years, being either equal or in a determined lesser proportion to this amount, a special assessment being substituted in cases where this formula would be, for any reason, inappropriate. Subsequently, after the elapse of the transitional period, the quotas might be revised annually in accordance with the actual volume of trade in the three preceding years.

A charge of 1 per cent. per annum will be payable to the Reserve Fund of the Clearing Union on the average balance of a member-State, whether credit or debit, in excess of a quarter of its quota; and a further charge of 1 per cent. on the average balance, whether credit or debit, in excess of half its quota. (ibid)

The keen reader will notice that in the above quote Keynes advocated levying penalties and limits not only on debtors to the system but also on creditors. These penalties were sure to be "valuable inducements towards keeping a level balance", as Keynes put it. Eichengreen draws attention to a more self-serving motive for Keynes's plan. Envisioning large US surpluses after the war (and large UK deficits), Keynes wanted to devise a way that would soften the effects of these imbalances on the UK by giving the nation time to rebalance, while at the same time penalizing the US for its large credit position. It was not to be, of course, as the ICU never came into being, displaced by the IMF and (to a degree) the Marshall Plan.

In addition to imposing a 1% charge per annum on surpluses above one-half of their quota, listed below are Keynes's specific proposals on credit limits:

A member-State whose credit balance has exceeded a half of its quota on the average of at least a year shall discuss with the Governing Board (but shall retain the ultimate decision in its own hands) what measures would be appropriate to restore the equilibrium of its international balances, including—

(a) measures for the expansion of domestic credit and domestic demand;

(b) the appreciation of its local currency in terms of bancor, or, alternatively, an increase in money-wages;

(c) the reduction of excessive tariffs and other discouragements against imports;

(d) international loans for the development of backward countries.

I doubt modern Germany would accept a 1% penalty on its massive Target2 balance, or that it would let itself be shoehorned into increasing wages or expanding domestic credit so as to help its neighbors solve their Target2 imbalance problem.

As for debtor countries, Keynes envisioned that countries would not be able to increase their debit balances by more than one quarter of their quota without the permission of the ICU Governing Board. In the case of debit balances in excess of one-half of its quota, the Governing Board could force the country to reduce the value of its currency or impose controls on capital outflows. When debit balances exceeded three-quarters of the quota, the Board could put the debtor nation under a form of financial shunning in which

it may be asked by the Governing Board to take measures to improve its position and, in the event of its failing to reduce its debit balance below the figure in question within two years, the Governing Board may declare that it is in default and no longer entitled to draw against its account except with the permission of the Governing Board. Each member-State, on joining the system, shall agree to pay to the Clearing Union any payments due from it to a country in default towards the discharge of the latter's debit balance and to accept this arrangement in the event of falling into default itself.

Anyhow, the point of all this is to show how the ECB is bereft of any form of control over its clearing members in comparison to what the ICU Governing Board would have exercised over its own members had it been established as per Keynes's plan. This may be one of the problems in forming a currency union. In order to motivate the political will necessary for the creation of any sort of international clearing union, prospective members can only be enticed to join by proposing systems with weak central control over member nation finances. But in order for a currency union to work, strong and systematic rules must be set in place prior to the system's debut. Thus the more robust ICUs of the world are destined to never get off the ground, whereas shaky propositions that should never get off the ground (like the ECB) do get off the ground.

Thursday, September 6, 2012

The Rowe/Glasner/Sproul debate continues over hot potato-ish-ness of money. Here is Nick Rowe:

The hot potatoes simply pass from one hand to another. Unless they sell it back to the banks, to buy IOUs. But why would they want to do that? If I have opals I want to get rid of I will probably sell them at the specialised opal dealer, who will probably give me the best deal. If I have money I want to get rid of....well, everyone I deal with is a dealer in money. The bank is just one in a thousand. Why would we assume that the bank will always give me a better deal than the other 999?

Mike Sproul jumps in, but David doesn't, so instead I left a comment trying to anticipate what David would say:

Sunday, September 2, 2012

Miles Kimball gave me some help on understanding Wallace Neutrality, which in turn might help me understand more where Stephen Williamson is coming from when he says QE is irrelevant. I asked Miles:

I'm not sure if I entirely understand the Wallace neutrality argument.

If I may paraphrase, does it mean something like... the Fed could buy a bunch of stocks on the NYSE, and they might be able to push their prices up (their dividend rates down). But if they did so, the price of these stocks would rise above their intrinsic value and profit-seeking agents would immediately take the opposite side of the trade, thereby pushing the purchased stocks' value back to their intrinsic value. So in order for the Fed to permanently increase stock prices above their intrinsic value, there must be some sort of "friction" that prevents profit-seeking agents from taking the other side of the trade. Is that what it means?

Miles:

Yes... You said it very well.

That's a relief. Sometimes I have troubles translating the somewhat Spockian language of formal economics into words that are more comfortable to me, that being the daily lingua of the marketplace, trading, and investing.

To further re-translate, I'd say the idea of Wallace Neutrality falls in the same boat as the old trader's adage... don't fight the Fed. If traders believe the Fed is all-powerful and too strong to trade against, then the Fed can effectively change assets prices above or below what they should otherwise be. If traders think they can fight the Fed, then the Fed can't change asset prices - traders will collectively take the other side of any Fed action, canceling out any Fed-induced price changes. What "friction" motivates traders to believe they can or can't fight the Fed?

Here is my older post on Stephen Williamson's QE irrelevance. The frictions I point to in that post are the Fed's size relative to other actors in asset markets and the Fed's ambivalence to profits/losses in a environment in which all other actors are hypersensitive to profits/losses. In other words... don't fight the Fed. It's massively big and doesn't care if it loses on the trade.

Brad DeLong had a comment on the idea of Wallace Neutrality here. Miles goes into the idea of Wallace Neutrality again here.

David's post comes on the heels of a number of other posts by various bloggers. See here, here, here, here, here, here, and here. Here is David:

A narrow view of "microfoundations" is reflected in the idea that the methodology of microeconomic theory (specifying individual preferences, information sets, endowments, constraints, together with an equilibrium concept) can and should be brought to bear on macroeconomic questions. This is in contrast to an earlier methodology that specified and estimated behavioral relations at the aggregate level. (One can legitimately weigh the pros and cons of these (and other) methodologies.)

Not many macro models are "microfounded" in a pure sense. Almost all models make at least some assumptions that may be viewed as ad hoc and provisional (subject to further investigation). I think of an ad hoc assumption as a restriction on behavior that is inconsistent with other aspects of the model, like maximizing behavior.

...just take a look at one of the dominant paradigms in macroeconomic theory--the New Keynesian framework. As anyone who is familiar with the paradigm knows, it is built around models that embed ad hoc assumptions reflecting the alleged costs associated with nominal wage and price adjustments in auction-like settings

...By the way, I like to take a broader view of "microfoundations;" or, rather, the search for microfoundations. Microfoundations does not, in my mind, mean stopping at preferences and technology, or anywhere else, for that matter. It simply means seeking a deeper understanding.

I like this broader view. At some point, perhaps, microeconomics will find its own microfoundations in behavioral economics and psychology, which in turn will be microfounded in neuroscience, which in turn...